The power of community banks

For both Democrats and Republicans, supporting community banks is an easy decision. Local banks exist in every congressional jurisdiction and have built trust with local communities. Being on the wrong side of community banks can have serious consequences for politicians.

On Thursday, Hillary Clinton demonstrated her support for community banks with a new agenda fact sheet, arguing that "many community banks and credit unions still struggle with unnecessary regulatory complexity." Clinton reasserts that she'll "veto any effort to weaken Wall Street reform," and the plan doesn't sneak in changes aimed to benefit the biggest players, for which community bank relief often covers.

But the proposal is also representative of an unfortunate tendency among politicians to overstate the difficulties community banks face. While most attention on Dodd-Frank has focused on the efforts of big banks to water down the financial regulations, community banks have received an astonishing amount of carve-outs and benefits. They’ve done this facing no opposition—conservatives want to use them to argue Dodd-Frank goes too far, liberals falsely hope they can be a countervailing pressure on Wall Street, and politicians want their support. But in addition to leading to increasingly bad policies, it can undermine the overall effort of reform.

Community banks, like auto dealers, are everywhere. And like auto dealers, reformers underestimate the significant amount of political power they wield. Even in the most broken and polarized Congress in decades, acts championed by community banks sail through as standalone legislation or attached to must-pass bills with barely any notice. Rather than a bulwark against the largest banks, community banks are just as likely to support changes that would help the largest banks while providing no new protections on them. Meanwhile research shows that community banks are doing fine financially, not struggling from regulations as most coverage shows.

To understand why the plight of community banks is overstated, the first thing to remember is that the large majority of Dodd-Frank applies to larger institutions deemed systemically risky, usually those starting around $50 billion dollars in size, and then accelerating for those over $500 billion. Community banks, generally defined as banks with less than $10 billion in assets, are either not part of these rules or often specifically exempt from them.

This was by design. As the Congressional Research Services found, 13 out of 14 of the most important Dodd-Frank rules¦ relating to banks “either include an exemption for small banks or are tailored to reduce the cost for small banks to comply.” Community banks are absent from some of the biggest controversies as well. The Consumer Financial Protection Bureau is only the primary supervisor and enforcement authority for banks with more than $10 billion in assets. Regulations limiting the fees banks can charge businesses for using debit cards only impacts banks with more than $10 billion in assets.

But even that understates the power of community banks. A Congress that can barely function under normal terms is adept and agile when it comes to addressing problems faced by small banks over the past several years. Take “save to win” programs, where people who save a small amount of money are eligible to win a big monthly raffle offered by a bank. In Michigan, for example, a credit union offered people who saved $25 in their savings account to be in a monthly drawing that could win $3,750; it’s a smart program that uses lottery impulses for the better outcome of helping people save. But, since it can legally look like a lottery, it could possibly run up against laws and regulations prohibiting banks from getting involved with lotteries. That’s why the American Savings Promotion Act, which informed regulators that banks are allowed to offer these programs, passed Congress unanimously in 2013. Virtually no other subsection of an industry can get such a quick and effective response from an otherwise totally dysfunctional Congress.

Or take bills clarifying and tweaking the language for major pieces of legislation. This normal process shut down in 2010. Famously, Democrats weren’t able to amend the Affordable Care Act to make it clear that health care subsidies were meant for exchanges established by a state. Normally this would have been fixed, yet conservative legal activists forced the issue to go to the Supreme Court.

This is not the case with small banks and insurers. When it wasn’t clear whether the Federal Reserve would be forced to apply capital requirements to insurance companies in the wake of Dodd-Frank, Congress passed the Insurance Capital Standards Clarification Act (April 2014) unanimously. When it wasn’t clear from the evolving regulations whether federal deposit insurance would cover various escrow accounts held at credit unions, Congress passed the Credit Union Share Insurance Fund Parity Act (December 2014) to make sure it would.

Community banks have flexed their muscles in much more aggressive ways. Congress doubled the Small Bank Holding Company threshold from $500 million to $1 billion (December 2014), meaning that a much weaker regulatory threshold would apply to banks under $1 billion dollars.

The reauthorization of the Terrorism Risk Insurance Program (January 2015) included a provision that amends the Federal Reserve Act to require the president “to appoint at least one member with demonstrated primary experience working in or supervising community banks” to the board of the Federal Reserve. (Senator Richard Shelby is currently blocking President Barack Obama’s nominees to the board, including the community bank representative.) It’s not clear what giving community banks an outsized role here has to do with managing the financial risks of terrorism. Like finance overall, community bankers probably would prefer tighter money at the expense of full employment, and, as such, are a poor fit for directing monetary policy. But either way if Goldman Sachs and Morgan Stanley demanded that the President be required to put a former investment banker on the Board of Governors there would have been massive political blowback; instead most people didn’t even notice this change.

The biggest relief was the Fixing America’s Surface Transportation Act, also known as the highway bill passed in December, 2015. Tucked inside this must-pass act were provisions doubling to $1 billion the size where banks only need a full examination once every 18 months, rules pulling back on regulations and protections for risky mortgage offered in rural and underserved areas for banks less than $2 billion in assets, an act that expanded the registration threshold for thrifts having to register with the Securities and Exchange Commission, and a law that ensures that community banks are exempt from the cuts to the special dividend the Federal Reserve pays banks.

The dividend change is worth careful examination. For years, progressive activists have fought to end the special dividend the Federal Reserve pays banks, calling it their “most brazen and least known handout.” This generous dividend came out of the initial structure and marketing of the Federal Reserve a century ago, and reformers argued it made no sense in our current economy. Congress agreed when it finally ended this gift by cutting the high rate the dividend paid. Except to do it, community banks had to be immediately carved out of this. Note that this has nothing to do with regulations, red tape, or overly strict enforcement. This is simply about a cash payment, free money the Federal Reserve gives to banks, and though progressives were able to remove it for the largest players, they had no success with the smallest ones.

It would be one thing if community banks were fighting for a broader and safer financial market. It’s a dream of reformers to try and have small players rise up and fight against the largest players, forming a broad alliance for a better economy. But this hasn’t happened. None of the Independent Community Bankers of America’s Plan for Prosperity, their ideal deregulatory agenda, involves tougher regulations on the biggest banks. If anything, it pushes for weaker rules on the top players.

There are no doubt sensible items for the smallest players in this platform, but the big asks involve raising the $50 billion dollar limit for when Dodd-Frank’s rules really start to kick in, a major gift for midsized banks that does nothing for community ones. Worse, raising that limit then creates pressure for raising higher thresholds for large regional banks. Beyond that, they’d also want to get rid of the “disparate impact” causes of action in the Fair Housing Act, change the structure of the CFPB to a board, and weaken the Volcker Rule for midsized firms. These would help the bottom line of the smallest players but more directly benefit the largest ones, and would do so at the expense of consumers and safety. It’s a broad alliance, but one among banks rather than society.

But the ultimate reason to think more clearly about relief for community banks is that they are doing much better than most people realize. As the Council of Economic Advisers argue in a recent report, lending “by all but the smallest community banks has increased since 2010.” Across a wide variety of measures, from lending to geographic reach, larger community banks are doing quite well.

Instead, the real threats to community banks are twofold, and have nothing to do with Dodd-Frank. The first is a long-term decline in the market that goes back to the original wave of deregulation in the 1990s. As the FDIC notes, almost all the institutional changes are occurring among the smallest of the community banks, those with less than $100 million dollars in assets, as they merge and grow into larger community banks. The number and total assets for community banks between $100 million and $10 billion increased. However the number of banks with less than $100 million in assets declined 85 percent between 1985 and 2013. This wasn’t because of their rate of bank failure, which was actually lower than other institutions. Instead, it was driven by voluntary mergers and acquisitions, mostly by other community banks.

The policies behind this have nothing to do with Dodd-Frank, but instead a series of reforms, most notably the Riegle-Neal Act of 1994, that allowed for interstate banking. Before then, the legal regime was consciously built toward much smaller and more local banks and protecting them from competition. This time period also brought a massive consolidation among larger banks, giving us a more top-heavy industry with the largest players having a larger share of assets, than in decades past. The landscape is still processing these changes, but it looks like they may be leveling off in the aftermath of the crisis. The CEA notes that community banks lost a dramatic amount of market share to big banks after 1994, but that in recent years, “the trend now is toward stabilization of, or even regaining, community banks’ market share.”

The other headwind for community banks is the weak economy and the era of consistently lower interest rates often referred to as “secular stagnation.” Researchers at the Federal Reserve constructed a model that found “at least 75% of the decline in new bank formation would have occurred without any regulatory change” and that low interest rates and overall economic weakness are the bigger drivers. The fact that 10-year Treasuries fell from 2.25 percent to 1.5 percent this year, a sign of continued economic headwinds, put far more pressure on bank income than any reporting statement.

None of this means that there aren’t common sense things we can do to help community banks, an essential lifeblood for credit for our economy. Our focus should be on shadow banking and the way credit intermediation and banking risks occur outside the traditional FDIC-insured banking system. Though it's possible we'll need more regulations on small banks too, especially in disclosures to monitor the health of the financial sector overall. But between free money in the form of Federal Reserve dividends, an outsized influence on monetary policy, and a vocal policy that would weaken financial reform overall, we can see the negative consequences of just handing community banks a blank check. We should be equally worried about doing too much, things that put the goal of strong financial markets at risk.

Mike Konczal is a fellow with the Roosevelt Institute, where he works on financial reform, unemployment, inequality and a progressive vision of the economy. Follow him on twitter.